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Shariah Law Guide

 

Implications on Risk & Return

As is the case with other ethical investment vehicles, an extra layer of rules restricts fund managers from certain investments which some argue may result in lower returns or more volatility than equivalent counterparts that can invest more freely in a larger investment pool.
Because of the concept of risk sharing and the restrictions on Riba and gambling, Shariah compliant funds are less able to invest in financials, companies that are heavily leveraged, and dividend paying equities which can potentially affect risk and return.
In particular, financials are traditionally very stable investments with low volatility – although recent history has shown nothing is ever a safe bet thanks to the credit crunch – and they often included in investment portfolios to calm this risk factor.
Dividends are usually paid by well established large companies that are again traditionally more stable investments. The problem with dividends is that most companies in the contemporary stock market usually partake in some form of interest bearing activity, as interest is earned by simply keeping funds in a conventional bank account, some of the interest that is earned filters through to dividends therefore making them Haraam. Nonetheless, generally accepted principles allow for some impermissible income, which is capped at 5% of total revenue.
Additionally, there are 2 other generally accepted accounting restrictions in Shariah investing that will affect investors. First, Shariah compliant companies must maintain a debt to equity ratio that is less than 33%, prohibiting Muslims from investing in highly geared companies which often give higher returns in terms of capital gains. Moreover, compliant companies are only allow to have less than 45% of accounts receivable as a percentage of debt to equity.
Shariah compliant funds do have ways to circumvent some restrictions, for instance Muslims can invest in dividend paying investments and open conventional bank accounts if the interest is nullified by a process known as ‘Purification’, whereby additional earnings are given to a charity for example (for the conventional investor this is an obvious loss on potential returns). Moreover, sometimes there are different interpretations and revisions to Shariah rules for example one recent development is a debate between scholars about whether certain trading practices and derivatives today are really Haraam.
Shariah Advisory Board
Shariah compliant funds have to be supervised by a group of accepted Islamic scholars that vet investment instruments and companies that the fund invests in, advise fund managers on the various issues surrounding Shariah investments and also conduct continuous due diligence on invested funds to ensure that everything is Halal and complies with Islamic Shariah law.
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